A while ago I read that Jack Bogle predicts that equities will return only 4% over the next decade. And that already includes dividends and it’s nominal, not real! People call me pessimistic with my equity return assumption for stocks, but good old Jack takes it down another notch. Here’s the quote, reproduced on CNBC:
“Just for mathematical reasons, the dividend yield is 2 percent, a little under 2 percent in fact, and the long-term dividend yield on stocks is pretty close to 4 … the earnings growth on stocks has been a little over 5, that’s going to be a very tough target in the future so let’s call it 4 … 4 and 2 percent give you a 6 percent investment return, but then you have to take … the valuations in the market. …You take that 6 percent return and maybe knock it off a couple of points perhaps for a lower valuation, slightly lower valuation over a decade and you’re talking about a 4 percent nominal return on stocks. And that’s low, lower than history. History is around 6 and a half.”
Wow! That’s a bummer: 4% nominal means about 2% real with a generally agreed upon 2% annual inflation rate. Or another way to look at this return prediction: If we assume that equities pay around 2% in dividend yield, then the equity price index will go up by only the rate of inflation. For ten years!
Everyone in the FIRE community should take notice. If you’re still in the accumulation phase you’ll likely need longer to reach FIRE. If you’re already retired and apply the good old 4% Rule then a Bogle-style scenario will likely put some strain on your portfolio. So, in today’s post let’s look at what the Bogle scenario means for Safe Withdrawal Rates in Early Retirement.
How crazy is Bogle’s prediction?
One little pet peeve I have with Bogle’s analysis: When he says “History is around 6 and a half” he seems to confuse real and nominal returns. Whether you take returns since 1871 (as we do) or 1926 (as they do in the Trinity Study), the average real total equity return has been about 6.7%. So, a 4% nominal return minus 2% expected inflation is a whopping 4.7% p.a. below and not just slightly below historical average.
But Bogle’s assumption is not crazy at all. The current Shiller CAPE is about 30, so according to my personal rule of thumb, this translates into an expected real return of 3.3% (=1/CAPE), but with some substantial uncertainty around it. Taking off another 1.3% safety margin and you’re right at Bogle’s estimate. In fact, if I had to pick among the two widely cited “crazy predictions,” 4% from Bogle and the 12% estimate from Dave Ramsey, I’d try my luck with the Vanguard guy!
What do we do now?
Are we all screwed now? Should we delay our Early Retirement? Run for the hills, sell stocks and go into bonds? Hold your horses! Just like Oracles from Ancient Greece, this Oracle of Valley Forge (Vanguard Headquarters) made a prediction with a lot of ambiguities. Even if we take the 4% prediction at face value, notice the two extremely important pieces of information Bogle didn’t elaborate on:
- What are his return expectations for year 11 and onward?
- 4% annual returns implies a cumulative compound return of about 48% in year 10. But what’s the path for equities in between? As we have learned from our research on Sequence of Return Risk (see part 1 and part 2), in retirement, the average return is much less important than the order/sequence of returns.
So, let’s look at the two issues:
1: What comes after year 10?
Notice what Bogle didn’t say: He didn’t say that the 4% return will persist beyond year 10. The way I interpret Bogle’s quote is that the next 10 years are merely an adjustment process. We have slightly lofty equity valuations and that underwhelming equity return will bring equity valuations back to normal. This view would be supported by that other oracle, the one from Omaha who had this to say last year:
“For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs.” Warren Buffett in 2016 letter to Berkshire Hathaway shareholders.
So, my interpretation of Bogle’s quote is that the 4% return assumption is only temporary, not permanent. Let’s assume that the Price index grows by only 2% (4% minus dividend yield) and profits keep growing at just 4%, i.e., about in line with nominal GDP. Historically, nominal GDP grew faster than that and profits grew even a little bit faster than nominal GDP, but let’s be conservative here. As the profits starting point, we use the $105.52 EPS figure from S&P for the second quarter of 2017 (estimate as of 6/6/2017). I also use a 2429.33 S&P level from yesterday’s (June 6, 2017) close.
Equity valuations will look quite attractive again after 10 years, see the table below. The PE ratio goes down to under 19 and the Shiller CAPE ends up in the low 20s, much closer to the historical average. With valuations like that, we can again expect much more generous returns going forward! If equities return to anywhere close their historical average returns (6.7% real) in year 11, then the 10 years of lean returns may not be too damaging to our FIRE strategy!
2: Sequence of Return Risk
To deal with the Sequence of Return Risk issue, let’s look at 3 scenarios: the Boring Bogle, the Bad Bogle, and the Good Bogle. Try to say this three times in a row as fast as you can!
- Boring Bogle: Equity returns are exactly 4% nominal every year for 10 years.
- Bad Bogle: Equity returns are -30% over the next year, then flat in year 2 and then +9.8% for 8 more years. This averages out to exactly 4% compound return over the 10 years.
- Good Bogle: Equity returns are 9.8% for 8 years, then flat in year 9 and -30% in year 10. Again, the average return is exactly 4% p.a.
Hold on, didn’t we forget something? How about bond returns? With the assumptions above we can only simulate a 100% equity portfolio, which is not too far away from our personal portfolio but may not be acceptable for many others in the FIRE community. Well, Jack Bogle didn’t mention anything about his return assumptions for bonds, so I can “make up” my own numbers, right?
Here are the assumptions on the 10-year bond yields. In all three scenarios, we start with an initial yield of 2.2%, the value as of early June. Since then the yield dropped to 2.15% on June 6, but the difference is small enough to not materially impact our simulations,
- Boring Bogle: From the initial yield of around 2.2%, let’s assume that the 10Y yield climbs to 3.2% in a very gradual fashion: 0.10% per year.
- Bad Bogle: The yield will also end up at 3.2% after 10 years but it has to take a very different path: In response to the equity crash and likely recession early on, the Federal Reserve again slashes interest rates and probably starts some other monetary easing programs (QE4, QE5, etc.) and causes a drop in yields initially, but then we observe a rapid rise back to 3.2% by the end of year 10.
- Good Bogle: Interest rates rise much faster in response to the strong economic expansion. The 10-year yield reaches 4.3% in 2025 after a record-long expansion of 16 years. Then we experience a drop in yields back to the 3.2% after the Fed uses monetary easing.
The bond returns assume that you hold an ETF of 10-year Treasury bonds that constantly rolls out bonds when their maturity falls too far below the target maturity and rolls in new bonds as their maturity reaches 10 years. Notice how this is different from holding one 10-year bond today until maturity (which is not what most bond ETFs are doing). See the assumptions below:
Due to the high duration (interest rate sensitivity of the 10-year bond), we get this nice diversification benefit of the bond portfolio: Very high returns in years 1-2 during the Bad Bogle scenario and years 9-10 in the Good Bogle scenario. Exactly when the equity portfolio is down! Also notice that in the Boring Bogle scenario when bond yields move up slowly, the realized bond returns are lower than the yield. That’s because you constantly lose to the duration effect, -0.80%, which is due to the 0.10% increase in yield multiplied by a duration of 8.0. (current estimate of the iShares 7-10 year Treasury Bond ETF, ticker IEF duration is 7.51).
- 10-year horizon, at an annual frequency.
- Withdrawals occur at the beginning of the year.
- Stock/Bond allocation between 50/50 and 100/0. We also throw in two equity glide path scenarios starting at 60% and 80% equities in year 1 and then shifting to 100% equities in 5% increments.
- We look at three initial withdrawal rates: 3.0%, 3.5% and 4.0%.
The results are in the table below. We display two crucial final outputs:
- The final real portfolio value after 10 years, as a percentage change relative to the starting portfolio.
- The year 11 effective withdrawal rate if we wanted to keep withdrawing the initial amount adjusted for inflation.
Summary of results:
- There is no hiding from the Bogle scenario. The portfolio value after 10 years will be down, and it’s mostly a matter of by how much.
- Bonds are an even worse investment than stocks. The final portfolio value is decreasing in the bond share. If you view Bogle’s warning as a call to reduce the equity share in your retirement portfolio, you couldn’t be more wrong!
- A glidepath with an initial bond allocation and then shifting into 100% stocks over time could serve as a hedge against the Bad Bogle scenario. Of course, if we’re in the “Good Bogle” scenario you still are better off with 100% stocks, so the glidepath scenario merely serves as a hedge against a worst-case scenario.
- The glidepath with 80% starting point seems to have the most consistent and robust final outcome. All year-11 withdrawal rates fall into the low 4% range when the initial SWR was 3.5%. Starting with 60% bonds might be too much bond exposure because if you’re “unlucky” and the equity bull market continues for 8 years only to end in a crash in years 9-10, then the glide path from 60-100% would imply a 4.68% withdrawal rate in year 11. That may be a little too high for comfort even if the CAPE is back to just above 20.
- A 3.0% SWR looks too conservative! The 80/20 to 100/0 glidepath ends up with an effective withdrawal rate of 3.32-3.46% in year 11. If we believe that equity and bond valuations have returned to a more normal level by then we should easily support a withdrawal rate in the low 4% range. Especially considering that we have already run down the retirement clock by 10 years.
- The 4% initial SWR seems way too aggressive. The static portfolio allocations all end up with a 6%+ effective WR in year 11 under the Bad Bogle scenario and also significantly above 5% in Boring Bogle scenario. In year 11 you’d have two choices: Either continue with the withdrawal path and risk running out of money or significantly reduce the withdrawals at that time. Not a pretty picture!
The more I look at the research on Safe Withdrawal Rates the more I like the 3.5% Rule. It’s high enough to not significantly delay anyone’s FIRE plans. If you have been planning on a 25x annual spending (4% rule) you are now looking at a target of “only” 28.6x spending. Come on, that’s not so hard! And it’s low enough to weather even this unpleasant Bogle scenario.
The other lesson from this exercise: Becoming too risk-averse and lowering the SWR to 3.0% or even below may actually be too conservative! How about that? As someone who is a perennial skeptic, I finally have some good news for the FIRE community. Chill out, everybody, you don’t have to go that low. A 3.5% SWR is all you need!
We hope you enjoyed today’s post! Please leave your feedback below!
- Part 1: Introduction
- Part 2: Some more research on capital preservation vs. capital depletion
- Part 3: Safe withdrawal rates in different equity valuation regimes
- Part 4: The impact of Social Security benefits
- Part 5: Changing the Cost-of-Living Adjustment (COLA) assumptions
- Part 6: A case study: 2000-2016
- Part 7: A DIY withdrawal rate toolbox (via Google Sheets)
- Part 8: A Technical Appendix
- Part 9: Dynamic withdrawal rates (Guyton-Klinger)
- Part 10: Debunking Guyton-Klinger some more
- Part 11: Six criteria to grade dynamic withdrawal rules
- Part 12: Six reasons to be suspicious about the “Cash Cushion“
- Part 13: Dynamic Stock-Bond Allocation through Prime Harvesting
- Part 14: Sequence of Return Risk
- Part 15: More Thoughts on Sequence of Return Risk
- Part 16: Early Retirement in a low return environment (The Bogle scenario!)
- Part 17: Why we should call the 4% Rule the “4% Rule of Thumb”